China stock probe should boost, not hurt sentiment

Investors should cheer China's probe into stock-price manipulation as it builds a foundation of trust as Beijing opens its capital markets to foreign investment, one expert said.

The China Securities Regulatory Commission (CSRC) announced late on Friday that it was examining possible charges of manipulation amid rapid price gains in 18 shares, 15 of which are small-cap firms traded in Shenzen, including Cloud Live Technology, Shanxi Baiyuan Trousers Chain Management and Shandong Xingmin Wheel.

The probe sparked heavy selling amid small-caps on Monday, with the ChiNext index sliding over 5 percent, the biggest drop since 2013.

The investigation should be viewed as a positive factor as it's aimed at improving the image of the stock exchange rather than cracking down on market players, said Hao Hong, managing director of research at BOCOM International.

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"The CSRC has identified a number of companies in potential violation of stock trading rules and they have been preparing for this for the past two years: They've been importing Chinese-born experts from the American SSEC investigation unit. They pay them to build up an investigative team to probe into irregularities so by now, CSRC should have pretty strong capabilities in detecting illegal activities," Hong told CNBC on Tuesday.

"The probe is also designed to protect the smaller investors, who have been in a position of disadvantage in the past. There has been quite a bit of rigging going on so now, the CSRC is leveling the playing field though it's going to reduce the transaction costs for many of the other guys," Hong added.

Public perception

Foreign investors have traditionally viewed Chinese financial systems and economic data with a suspicious eye due to an overall lack of market transparency and companies presenting unreliable financial information. Financial reforms will be prioritized in 2015, as indicated by policy makers at the recent Central Economic Work Conference, and will likely be a key factor determining future market sentiment.

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"While some attention will surely be placed on financial sector reform, it is almost certainly going to be gradual; most likely a gradual widening of permissible interest rates above the benchmark deposit rate, as well as market entry for some joint-venture or private banks in limited segments of the commercial banking sector," noted Brian Jackson, China economist at IHS Global Insight.

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"Banking and finance authorities have repeatedly made clear their view on the importance of proper sequencing of reforms, indicating a likely implementation date of 2016 or 2017 for the most ambitious measures," he added.

Don’t worry about the rally

Traders are wondering how sustainable China's equity rally is with the Shanghai Composite Index up nearly 50 percent year-to-date. Its Relative Strength Index (RSI) now stands at 72, which is well into overbought territory. However, Hong warns that the market's fundamentals remain intact.

"Yes, the rally we're seeing right now is unprecedented, even including 2007's bull market run...Even though the rebound has been very sharp, if you look at the overall market valuation, it's still about 14x, compared to 2007 when it was 60-70x. So, this is the major difference. When people say we're taking on excessive risk, it isn't true because the market is still cheap in China."

Others have taken on a more cautious stance, preferring to stay risk-averse.

" I think people get caught up with the momentum. They see a share price going up and that gives them more confidence. We got into the market very early and we're happy to take profits ahead of time," said Sam Le Cornu, senior portfolio manager at Macquarie Funds Group.